Sunday Musings: The Trillion Dollar Meltdown

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I just finished reading Charles Morris’s “Trillion Dollar Meltdown,” which describes the recent years of easy money, high rollers and the great credit crash.

According to Morris, an acclaimed financial writer, the sub-prime crisis is only a preview of the havoc that will play out across the full spectrum of financial assets. Arcane credit derivative bets are now well into the tens of trillions. The astronomical leverage at major banks and their hedge fund and private equity clients virtually guarantees massive disruption in global markets.

The book explains the arcane financial instruments, the chicanery, the policy misjudgments, the dogmas, and the delusions that created the greatest credit bubble in word history. Paul Volcker slew the inflation dragon in the early 80s, and set the stage for the high performance economy of the 1980s and 1990s. But Wall Street’s prosperity soon tilted into gross excess.

Now global confidence in American securities has been shattered, the dollar debased, and the crown jewels of American industry put on auction to foreigners. Continued denial and concealment could cause the crisis to stretch out for years, but financial and government leaders are still downplaying the problem.

This is where things can get ugly for your portfolio, if you don’t realize that a Black Swan event could be lurking around the corner. While you can’t do anything about the facts as Morris describes them in his book, you can take simple measures to protect your portfolio should the crisis accelerate. Have a disciplined entry and exit strategy and never ever work without the use of a sell stop.

The book is an easy read and will get you up to speed, in case you missed some of the developments leading up to the unwinding of the greatest credit bubble in history.

How To Invest $50 million Dollars

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There are many different viewpoints on how to invest your money, whether it is during the accumulation phase of your investment life or after you “have arrived.”

To my way of thinking, the approach for growing your assets is entirely different from the one you should use if you find yourself suddenly with a windfall in the range of 10s of millions of dollars.

One of my clients faced such a situation after he sold a portion of his business and had moved, as I refer to it, into the Investment EndZone. What is it?

It’s a state of financial independence that allows you to comfortably live off your investment income and assets without ever having to go back to work or take financial gambles.

Of course, the brokerage industry would want you to keep playing the same old investment game, since that has proven to be most profitable—for them. Take a look at the latest addition to my website called “
High Net Worth Strategy,” and download my free 6-page report, which explains my thinking and how my client Roger handled this situation.

You may not have reached that point, but I think it’s important for anybody to know how you can get shafted and/or misled by advice that is not in your best interest.

No Load Fund/ETF Tracker updated through 8/28/2008

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My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

Another whip-saw week with the major indexes closing to the downside.

Our Trend Tracking Index (TTI) for domestic funds/ETFs remains below its trend line (red) by -0.86% thereby confirming the current bear market trend.



The international index now remains -7.47% below its own trend line, keeping us on the sidelines.



For more details, and the latest market commentary, as well as the updated No load Fund/ETF StatSheet, please see the above link.

Borrowing Money

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In an appropriate sign of the times we’re in, the FDIC may have to “Borrow Money from the Treasury” according to the Wall Street Journal:

Federal Deposit Insurance Corp (FDIC) might have to borrow money from the Treasury Department to see it through an expected wave of bank failures, the Wall Street Journal reported.

The borrowing could be needed to cover short-term cash-flow pressures caused by reimbursing depositors immediately after the failure of a bank, the paper said.

The borrowed money would be repaid once the assets of that failed bank are sold.

“I would not rule out the possibility that at some point we may need to tap into (short-term) lines of credit with the Treasury for working capital, not to cover our losses,” Chairman Sheila Bair said in an interview with the paper.

Bair said such a scenario was unlikely in the “near term.” With a rise in the number of troubled banks, the FDIC’s Deposit Insurance Fund used to repay insured deposits at failed banks has been drained.

In a bid to replenish the $45.2 billion fund, Bair had said on Tuesday that the FDIC will consider a plan in October to raise the premium rates banks pay into the fund, a move that will further squeeze the industry.

The agency also plans to charge banks that engage in risky lending practices significantly higher premiums than other U.S. banks, Bair said.

The last time the FDIC had borrowed funds from the Treasury was at nearly the tail end of the savings-and-loan crisis in the early 1990s after thousands of banks were shuttered.

The fact that the agency is considering the option again, after the collapse of just nine banks this year, illustrates the concern among Washington regulators about the weakness of the U.S. banking system in the wake of the credit crisis, the Journal said.

Yes, considering this option this early in the game after the failure of only 9 banks is a troubling development and a clear sign that worse is to come.

The immediate question that comes to my mind is what happens if the losses of the anticipated bank failures exceed the current $45.2 billion dollar fund reserves? Sure, the FDIC will dip into their Treasury credit line to cover expenses, but then what? Who will ultimately foot the bill if there is a shortage, and most likely there will be?

Of course, you guessed it: The deep pockets of the taxpayer will as always be a ready and available resource to bail out failed institutions.

Stopping The Bleeding

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Monday’s sharp drop of the major averages gave the bullish crowd a lot to think about and confirmed our bearish stance. Follow trough selling was contained yesterday as the chart (thanks to MarketWatch) shows, with most of the activity being directionless bouncing around the flat line.

Despite sharp rallies and subsequent market drops we are now just about back to where the S&P; 500 started the month. The underlying cause for this confusion is of course the price of oil but also the realization that the problems in financial stocks will be with us for a while longer. Rating agency Fitch put insurance giant AIG on credit watch, because they are concerned that more large write-offs are looming.

As I have repeatedly said, until all skeletons are out of the closet, we will not see any normalcy in terms of fluctuations return to the market place.

As of yesterday, our Trend Tracking Indexes (TTIs) have moved to the following positions with regards to their long-term trend lines:

Domestic TTI: -1.06%
International TTI: -8.64%

We continue to watch things from the sidelines and will stay there until a clear breakout to bullish territory has materialized.

One Reader’s Investment Strategy

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Reader Fred shared with me his approach to investing, which has worked well for him over the past 10 years. Here’s what he had to say:

I subscribe to an advisory service called “The Chartist”. This service has had its subscribers 100% in cash since the middle of January 2008. So I am not invested in any mutual funds at the present time.

When I get a buy signal from the Chartist, I have followed a rule of investing only in no load mutual funds rated 5 stars by Morningstar. I only invest about 5 per Cent of my nest egg in any one mutual fund so I have about 20 mutual funds in my portfolio. I watch these funds closely using a computer program called Quicken. When any fund has a 10% loss, I sell it and invest in another fund rated five stars.

Why would you ever invest in a mutual fund which has a rating of less than five stars? Why not stay in the top 20% of funds as rated by a professional organization like Morningstar?
By using this simple system as described above, I have been able to double my nest egg after income taxes over the last ten years.

What do you think of my strategy?

Fred brings up some interesting points, and I am glad to hear that he has stuck with an approach that has worked for him for such a long time. I have found that most investors jump around way too much always in search of hoping to find the ultimate (and 100% correct) system. Of course, it does not exist.

Here are some comments I have about Fred’s approach:

First, I encourage any investment methodology that uses a discipline based on trend and momentum models along with clearly defined sell stops. The Chartist has done that for a long time and, while their approach differs from mine in some aspects, the core idea remains the same: Stay away from bear markets!

Second, if a 5% allocation works for you, that’s fine. I think that would be appropriate for stocks but is a bit of an over diversification for mutual funds.

Third, I personally don’t think much of the Morningstar ratings. I found them to be too much of a lagging indicator. From my experience, the result is that many rated funds are not necessarily in tune with current economic conditions at the time a Buy signal is generated.

Using momentum figures gives you a better picture as to which funds are showing superior performance at this time. After all, who cares what a fund has done 3, 5 or 10 years ago, I want to know how it is performing now.

Nevertheless, there is not just one method that is the correct one to use, because investing is not an exact science and every approach has its shortcomings and/or benefits. They key is to identify a method that aligns with your emotional make up and risk tolerance, and it appears that reader Fred has done just that.